Fair-Value Guesswork Is Best Left to Investors

April 30 (Bloomberg) -- As I struggled to navigate a
roundabout at London’s Heathrow Airport recently, I wondered why
the Brits don’t switch to driving on the right side of the road.
The main obstacle, of course, is the difficulty of ensuring that
all vehicles make the change at the same time. Just a few
holdouts, particularly trucks, could cause major problems.

This is an appropriate analogy for the current chaos in
companies’ financial statements as standard setters embrace
fair-value accounting. Some recent examples:

-- Fair-value loss equals accounting profit: During the
third quarter of 2011, growing worries about the sovereign-debt
crisis caused Bank of America Corp.’s stock price to plunge to
$6.12, from $10.96. Yet the bank’s financial statements for that
period show that book value per share rose to $20.80 from
$20.29, and the company reported earnings per share of 56 cents,
far exceeding analysts’ estimates and setting a new post-financial crisis record.

How did this happen? Current fair-value accounting rules
allow the bank to elect to treat the decline in the market value
of its debt as revenue, and that is what generated the bulk of
the profit. The idea is that the equity holders are better off
because there is now a greater chance that the bank will go
broke and not pay off its debt. But the presumed reason that the
fair value of the debt dropped in the first place was because
the value of the bank’s assets declined.

Yet under current accounting rules, the decline in the fair
value of the bank’s assets is largely ignored. For example, the
loan portfolio, its largest asset, is mostly valued at amortized
cost. Perversely, the result is that a decline in the fair value
of Bank of America’s assets leads to increased revenue, earnings
and book value.

-- Missing fair value: More generally, the current
piecemeal approach to fair-value accounting has done little to
bridge the gap between companies’ market values and book values.

Take the case of Apple Inc., the world’s most valuable
company. Its market capitalization exceeds $500 billion. Yet its
book value of equity is only $102 billion. A quick glance at the
balance sheet shows that most of this book value relates to cash
and investments, which total about $110 billion. The net book
value of the assets and liabilities related to Apple’s
technology business amounts to minus $8 billion. This total is
negative because Apple’s technology assets are valued at less
than the amounts owed to suppliers and employees. If we assume
that the fair value of cash and investments approximates their
book value of $110 billion, the market is essentially valuing
Apple’s technology business at more than $400 billion, even as
the financial statements value it at minus $8 billion.

The main reason for this gap is that the accounting for
Apple’s technology business is still based on the traditional
model, which summarizes past transactions. Market values, by
contrast, are determined by investors’ expectations about future
transactions. The traditional model reports relatively reliable
information about past transactions, leaving the more subjective
task of forecasting future cash flows to investors.

Nevertheless, the move toward fair-value accounting is
increasingly requiring accountants to forecast future
transactions and their associated cash flows. It is far from
clear that this move is proving helpful to investors. The
current method of accounting for intangibles illustrates why.

-- Fair or unfair?: Current accounting rules don’t
generally require companies to record their nonfinancial assets
at fair value, but there are exceptions. Perhaps the most
significant relates to “indefinite-lived” intangible assets,
such as the goodwill arising from acquisitions. Current
accounting rules make no attempt to systematically amortize
these assets against the revenue they are expected to generate.
Instead, they are initially valued at cost and then subject to
periodic impairment tests to determine whether their fair value
has fallen below their book value. If it has, book value is
written down to fair value.

So how effective are accountants in making these fair-value
adjustments? Take the case of Boston Scientific Corp.’s purchase
of Guidant Corp. in 2006. The acquisition raised Boston
Scientific’s total assets from $8 billion to $31 billion, adding
$20 billion of intangibles. The combination proved to be a dud,
generating no significant increase in profit and free cash
flows. Investors figured this out, and Boston Scientific’s
market capitalization is now around $9 billion, down from more
than $25 billion at the end of 2006. But the company is still
carrying $16 billion of intangibles on its balance sheet, mostly
goodwill from the Guidant acquisition. This despite the losses
the company has generated in five of the last six years. As a
result, the medical-device maker currently has a book value per
share of about $8, and a stock price of about $6.

Other companies with disconcertingly high fair values for
their intangibles include Sprint Nextel Corp., Legg Mason Inc.,
AOL Inc., EchoStar and CME Group Inc.

Of course, estimating the fair value of a complex business
isn’t simple. Boston Scientific acknowledged as much on Page 63
of its recent 10-K filing: “Although we use consistent
methodologies in developing the assumptions and estimates
underlying the fair value calculations used in our impairment
tests, these estimates are uncertain by nature and can vary from
actual results. The use of alternative valuation assumptions,
including estimated revenue projections, growth rates, cash
flows and discount rates could result in different fair value
estimates.”

Perhaps this is why accounting rules have traditionally
left the job of estimating uncertain fair values to investors.

-- Solutions: The traditional accounting model is organized
around recognizing revenue from past transactions and matching
those with associated expenses to produce periodic earnings. The
primary role of the balance sheet is to keep stock of benefits
and obligations relating to past transactions. For example, past
sales that are owed to a company are recorded in accounts
receivable. The key summary measure of performance under the
traditional model is the earnings attributable to periodic
revenue. Investors use this information as a starting point for
projecting future earnings and cash flows, which then are used
to estimate company value.

A pure fair-value accounting model attempts to directly
value a company on its balance sheet. We currently only see this
model in situations in which the fair value of essentially all a
company’s assets and liabilities is readily observable, such as
with stock mutual funds. Although this model works well for the
likes of the Vanguard S&P 500 Index Fund, it is much more
problematic for complex companies such as Bank of America, Apple
and Boston Scientific.

Current accounting rules are an incoherent mixture of the
two models above. They cling to traditional revenue-recognition
rules, while introducing ad hoc fair-value adjustments. This
results in balance sheets that rarely do a good job of measuring
a company’s fair value and income statements that are so
peppered with fair-value adjustments that it is hard to estimate
a company’s sustainable earnings.

Managers have responded with a bewildering array of “pro
forma” earnings adjustments. But in many cases, these
adjustments take legitimate costs of doing business and treat
them as if they were irrelevant.

An important objective of financial statements is to
produce useful measures of company performance. The current
accounting system is increasingly falling short in this respect.

Accounting standard setters should stick with the
traditional model and leave the task of estimating uncertain
fair values to investors. Readily observable fair values are, in
many cases, best left to other comprehensive income or footnote
disclosures.

In the meantime, investors would be wise to navigate
corporate financial statements with extreme caution.

(Richard G. Sloan is a professor of accounting at
University of California, Berkeley’s Haas School of Business and
a contributor to Business Class. From 2006 to 2009, Sloan was
director of equity research at Barclays Global Investors. The
opinions expressed are his own.)

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